The start of the year looked great for stocks of smaller companies as they led the market\u2019s January rally after a brutal 2022. What no one saw coming is that a regional banking crisis in March would drag down returns of the small-cap index and send jitters throughout the market.<\/p>\n
It may be time to buckle up, as small-cap stocks could be poised to take off again. <\/p>\n
\n
The near-term outlook for small companies is still bumpy, with lingering worries about the economy, tighter credit conditions, and the health of regional banks. But history tells us that small-cap stocks tend to underperform going into a recession and outperform coming out of one. There\u2019s also the small-cap effect to consider: the tendency of small companies to produce higher average returns than large ones over long time periods. <\/p>\n
Jill Carey Hall, head of U.S. small- and mid-cap strategy at Bank of America, says the firm\u2019s economists are calling for a mild recession this year, beginning in the third quarter and lasting till early next year. The market usually bottoms before the economy\u2014about six months before the recession is over\u2014and \u201csmall-caps usually bottom around the same time as large-caps and then outperform off the bottom,\u201d she says.<\/p>\n
Investors should take the long view when it comes to smaller companies. \u201cThere is certainly more potential for some downside risk near term,\u201d says Hall. \u201cBut if you do have a longer time horizon and can potentially withstand some further potential downside or volatility, the longer-term multiyear backdrop for small-caps does look attractive.\u201d About 8% of the
\n Russell 2000
\n small-cap index is composed of regional banks, compared with 1% for the broader
\n S&P 500.<\/span>
\n While that\u2019s not a big chunk of the index, \u201cif you\u2019re taking a relative position on small versus large-caps, it is significantly larger than the exposure in the large-cap index,\u201d she says. <\/p>\nWith so much turmoil in the markets, the coming months could be a time for active managers to shine. \u201cValuation dispersion is very high, with very cheap and very expensive stocks, and that presents opportunities for fundamental value investors to do stock-picking,\u201d says Hall. <\/p>\n
Indeed, some managers are outperforming\u2014and banking on better days for the sector. One of those is Chuck Royce, chairman and portfolio manager at Royce Investment Partners, a unit of Franklin Templeton. <\/p>\n
Royce is well known for its longstanding focus on the small-cap sector. Its flagship strategy, the $1.6 billion
\n Royce Pennsylvania Mutual
\n fund (ticker: PENNX), has outperformed the Russell 2000 for the one-, three-, five-, 10-, 15-, 20-, 25-, 35-, and 40-year periods ended March 31. For the year through April 30, the fund was up 5.78%, according to Morningstar Direct, handily beating the Russell 2000\u2019s gain of 0.89%.<\/p>\n
Royce, who has helmed the fund since its 1972 launch, says his team of managers scours the small-cap universe for businesses that look mispriced and underappreciated. \u201cThey must also have a discernible margin of safety\u201d to allow them to withstand challenging periods, he says. That is most commonly found in a strong balance sheet, which should allow a company to not only survive short-term difficulties but also position it to take market share from less conservatively capitalized competitors, he adds.<\/p>\n
The fund takes a multidiscipline approach that offers exposure to strategies that have tended to perform well in different market environments, including high quality\u2014companies that have high returns on invested capital, low-debt balance sheets, and are generating free-cash flow\u2014emerging quality, traditional value, and quality value. The fund, which holds nearly 300 stocks, has long favored cyclicals\u2014the most economically sensitive stocks\u2014including industrials and tech stocks.<\/p>\n
On the other end of the spectrum, with only 28 stocks in its portfolio, is the Morningstar five-star-rated
\n Davenport Small Cap Focus
\n fund (DSCPX), which returned 9.07% through the end of April. The fund, which has nearly $600 million in assets under management, has consistently outperformed, ranking in the top quartile over one, three, and five years. For the five-year period, it outperformed 99% of its category peers, according to Morningstar.<\/p>\n
Portfolio co-manager George Smith says the fund focuses on \u201cunique and underfollowed businesses that have idiosyncratic growth drivers.\u201d Its top two holdings are
\n NewMarket
\n (NEU), which produces additives for motor fuel, and
\n Monarch Casino & Resort
\n (MCRI), which the fund first bought in 2015. NewMarket is up 19% over the past 12 months, at $393.04, while Monarch is up 4.5%, at $67.27.<\/p>\n
The fund\u2019s consistent performance, adds co-manager Chris Pearson, is a function not only of the companies it owns, but also those it has avoided. \u201cWe have a strict discipline around high-quality businesses that generate substantial amounts of free cash flow and have capable management teams that can reinvest that cash at higher rates of return,\u201d he says. \u201cWe do not chase momentum.\u201d <\/p>\n
Pearson notes that a high percentage of companies in the Russell 2000 are unprofitable. \u201cWe way over-index to profitability,\u201d he says. \u201cInsider ownership is another element of our strategy that we emphasize.\u201d At Monarch, \u201cinsiders own north of 20% of the company,\u201d he says. The company has \u201ca rock-solid balance sheet\u201d that allowed it to weather the pandemic. <\/p>\n
Write to <\/strong>Lauren Foster at lauren.foster@barrons.com<\/p>\n<\/p><\/div>\nRead the full article here<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"The start of the year looked great for stocks of smaller companies as they led the market\u2019s January rally after a brutal 2022. What no one saw coming is that a regional banking crisis in March would drag down returns of the small-cap index and send jitters throughout the market. It may be time to […]<\/p>\n","protected":false},"author":1,"featured_media":7146,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"gallery","meta":{"footnotes":""},"categories":[241],"tags":[83],"class_list":["post-7145","post","type-post","status-publish","format-gallery","has-post-thumbnail","hentry","category-markets","tag-featured","post_format-post-format-gallery"],"yoast_head":"\n
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